ECB ponders reinvestment options

Pernicious politics of quantitative easing

by David Marsh and Ben Robinson in London

Wed 24 Oct 2018

When the European Central Bank started its public sector bond purchase programme in March 2015, there was plenty of discussion of adverse consequences. Monetary policy-makers, especially in Germany, recognised that the action could distort capital markets by imposing central bank asset purchases as a dominant determinant of interest rates.

Few could have foreseen that full-scale quantitative easing, long resisted by the German Bundesbank, appears generally to have benefited – and increased the relative economic weights of – the prospering northern states relative to languishing southern members of monetary union. Moreover, QE – through the innocuous technical-sounding device of the ECB capital key – has revealed itself as an instrument for reinforcing and even perpetuating regional inequality.

A mechanism that many northern critics allege has unfairly helped southern states has turned out to solidify the northerners' advantages. And, just at the time when the ECB wishes to phase it out, QE risks amplifying imbalances by causing northern states to overpurchase and southern countries to underpurchase their own bonds.

The pernicious politics of Europe's QE reflect the innate complications of carrying out unified monetary operations across a disparate 19-country region. These realities will overshadow the intricate technicalities of QE reinvestment next year. The ECB is ending net asset purchases because of the improved euro area economy – but the fruits of the recovery are unevenly spread. Italian and Greek GDP remains smaller than before the financial crisis, and what the ECB calls 'growth accidents' cannot be ruled out.

Reflecting this, the bank is cautious on phasing out monetary accommodation. It aims to keep the overall monetary stance unchanged by reinvesting the entirety of maturing bonds from national central banks' portfolios next year.

ECB rules would require reinvestments, over time, to bring each country's public sector debt holdings into line with their new capital key. The relative weighting of Germany and the Netherlands has increased, while that of Italy, Greece, Spain and Portugal has declined. This procedure would require significant purchases of German debt, and correspondingly lower buying of Italian and Spanish bonds – an outcome that could inflame anti-euro sentiment in southern Europe.

European central bankers have considerable leeway for applying discretion. The ECB and the NCBs that in practice carry out most of the buying have already in the past four years had to adjust purchases to offset the low uptake of a sizeable number of countries with relatively small bond markets. Cyprus, Estonia, Latvia, Lithuania, Malta, Portugal and Slovakia all lack outstanding securities to fulfil their allocation. These countries' central banks have underpurchased their countries' bonds by large amounts adding up to around €45bn.

Another reason for flexibility has been the non-eligibility for QE purchases of Greek bonds, as a result of Greece's sub-investment grade credit rating. As a result of these factors, the three largest countries, all with significant bond markets – Germany, France and Italy – have purchased a larger share of assets than foreseen under strict application of the capital key. These extra net purchases have allowed total buying volumes to meet the ECB's monthly quotas.

Reinvestment is likely to show similar flexibility. The period for each NCB to align its bond holdings with the new capital key could stretch up to five years. This would obviate the disruption that would ensue from adjustments under a shorter period. If the ECB decided, for example, to force each country to meet its new capital key requirement by end-2019, the Banca d'Italia might make no reinvestment next year – driving up further Italian interest rates and stoke fears of Italy's euro withdrawal.

However, extending the time frame could lead to awkward questions about how to deal with changing circumstances that made any countries' bonds no longer eligible for purchase. In the light of the dispute over the Italian budget – on 23 October the European Commission formally rejected Rome's draft budget, marking the first time Brussels has asked for changes to a country's spending plans – Italy could be heading into a downward spiral in which higher interest rates, higher deficits, lower growth, capital flight and ratings downgrades feed on each other.

An alternative possibility would be for the ECB to reinvest bonds in the original country of purchase. This would essentially freeze the end-2018 holdings of assets in each bond market, locking in the existing deviation from the capital key share. Reinvestment would thus have a more neutral effect, yet it would also require complex navigation. Should Greek bonds be upgraded to investment grade during the reinvestment period – an outcome that Athens' August exit from its multilateral bail-out package brings closer – reinvestments in other countries' bond markets would have to fall to the tune of Greece's updated capital key share of 2.4%.

In theory this reduction would come from countries with the largest positive deviation from their capital key share. As the largest deviation is in Italy, however, this would significantly reduce the share of Italian debt eligible for purchase. Moreover, it would lead to an awkward asymmetry in which reinvestment of maturing bonds was taking place in most countries, while net purchases were just being started in Greece.

As the ECB looks beyond net asset purchases, the updated capital key presents myriad complications. Flexibility in implementation and communication will be vital to ensuring market stability, but risks of political opposition and claims of unfair treatment among both debtor and creditor countries are likely to grow.

David Marsh is OMFIF Chairman and Ben Robinson is Deputy Head of Research. Additional research from Pierre Ortlieb.

This is the second in a series of three articles on the ECB's reinvestment policy. The first appeared yesterday. Part three will be published tomorrow.